If you’ve read about converting separately managed accounts or private investment funds into a new ETF using Section 351 of the Internal Revenue Code, you might think it’s an easy process. Think again. There are numerous ways to mishandle this intricate transaction. To execute it successfully, you need experienced tax counsel, securities counsel, and a meticulous team. Here are some common pitfalls in the tax-free conversion from SMA to ETF.⁽¹⁾

1. Miscalculating positions. For a transfer to satisfy the Section 351 requirements, each transferor’s portfolio must have its largest holding represent less than 25% of the total portfolio of that transferor. Let’s say you have a potential transferor whose portfolio consists of $990,000 of Microsoft stock and $3M of an S&P 500 ETF. You might initially think to yourself, “great, the Microsoft stock is slightly less than 25%, and I can do a look through regarding the S&P 500 ETF, so I am home free.” Not so fast. Microsoft represents about 6% of the S&P 500, which means when you add the direct ownership of Microsoft ($990,000) to the indirect ownership of Microsoft (6% of $3M or $180,000) you now have $1,170,000 in Microsoft, which is slightly over 29% and means you just flunked the diversification requirements.

2. Neglecting Risk Disclosures. Although a Section 351 conversion should be low-risk when planned and executed carefully, inherent risks still exist. Have you updated your registration statement to reflect these risks?

3. Trying to Herd Cats with a Pitbull. A successful Section 351 transaction requires smooth collaboration among many parties, including custodians, all Registered Investment Advisors (RIAs), transferors, the ETF sponsor, advisers, tax counsel, securities counsel, the Authorized Participant (AP), ETF accounting teams, and others. Key steps involve timely delivery of securities or information. We prepare extensive PowerPoint presentations outlining all 17 steps and responsible parties, along with hosting weekly “all hands” calls to ensure alignment.

4. Not Understanding Foreign Securities and other “Challenging” Assets. Weirdly, certain types of foreign securities and certain types of other assets can be included in a Section 351 transfer and certain ones cannot. Let’s just say that I am happy someone alerted me about a week before closing that Indian securities traded on the Indian stock exchange cannot be transferred in-kind.

5. Failing to Address Affiliated Transactions. You will need to ascertain if one or more transferors is deemed to be affiliated persons. Section 17 of the Investment Company Act of 1940 prohibits certain transactions between affiliated persons and registered investment companies, such as ETFs. Among other things, you will need to make sure that the parties comply with Rule 17a-7.

6. The Aggravation of Aggregating Accounts. Diversification tests often apply at the account level, but tax tests are assessed at the taxpayer level. For instance, if Mary has three accounts—her own, a marital account, and a trust account—you must aggregate these accounts and assess them at the “Mary” level, which can lead to interpretive challenges.

7. The Inhumanity of Dealing with Transferors That Are Not Individuals. Any transferor that is an entity (e.g., an LLC, a trust, or a corporation) will require additional analysis. Typically, but not always, there will be a way to accommodate such transferors, but there is important due diligence to do first.

8. Evaluating Inbound Securities. Let’s say the new ETF will focus on large cap domestic equities. Could a transferor transfer stock of a Brazilian company to the new ETF? Answering that question entails a deep dive into both the tax law and the securities law.

9. Fluctuations in Value. We did a Section 351 conversion for a wealth manager and its clients. The wealth manager had been clever enough to buy Google (Alphabet) about 20 years ago, and many of the clients had portfolios that were heavy on appreciated Google stock. A week or so before the closing, we evaluated each portfolio under the diversification tests. All were between 20% and 24.7% Google stock. We thought we were in good shape. But then, that week, Google appreciated dramatically in value, pushing many of the portfolios above the 25% limit. We scrambled around and changed the composition of some transfers so that we satisfied the 25% test, but it took some concerted effort and a conscientious and thorough team.

10. Economic Substance. Judge Learned Hand, who served on the United States Court of Appeals for the Second Circuit, stated in 1934 in the famous case Helvering v. Gregory that: “Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.” However, it is important to note that despite this viewpoint, the taxpayer lost the case. That’s right, despite the language supporting the taxpayer, once Judge Hand reviewed the entire transaction, he disagreed that the transaction met the intent of the law and ruled against the taxpayer. Hand concluded that a business transaction must have economic substance and must not be merely an attempt to reduce tax. It is probably beyond the scope of this short blog post to cover a vast topic like the economic substance doctrine, but suffice it to say that nearly every Section 351 transaction (and often related transactions) presents an issue dealing with the economic substance doctrine. This is an area where one needs experienced tax counsel.

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There are many other potential traps. Ensure you engage a knowledgeable team to navigate these complexities, such as the professionals at ETF Architect.